Value Investor Improvement Tip #1: Settle for Cheap Enough

People need practical advice on investing. And many of the articles I write are too theoretical. In fact, many of the questions people ask me are too theoretical.

They want to know about a certain way to value a company – should they use today’s free cash flow yield, an estimate of future growth out 10 years and then calculate the compound annual stock price rise to reach the future price as if the stock trades at a normal P/E in 10 years, should they calculate net current asset value using the book value of current assets or discounting each of the assets to reflect what they’d realize in liquidation, and so on...

There’s nothing wrong with these questions. And I do try to answer them as best I can.

But, knowing the answer to these questions is not the best way to immediately start improving your actual investing results. Most investors don’t need to know more to get better results starting today. They just need to get more out of the knowledge they’ve already got.

That’s what I want to talk about today. And hopefully I can keep talking about it over the next few days. I’d like to list a few ways you can start seeing better results in your brokerage account – using only what you already know.

Settle for Cheap Enough

A lot of people look for the lowest P/E ratios, the lowest P/B ratios, the highest dividend yields, stocks hitting new lows, etc.

Those could be fine stocks. But they’re likely to be controversial. And complicated. And quite possibly outside of your circle of competence. You’ll find a couple great stocks in any of those lists.

But it’s an odd way to start your search. It’s extremely limiting in terms of the kinds of companies you’re going to get a chance to look at. And – in a way – it’s too hard. It asks too much of you. Instead of having a list of companies you know something about – and could easily learn more about – you’ve got a list of stocks that are real outliers in some quantitative respective. And that’s it. That’s all you have to go on. A number.

For every 10 names you find on a screen, you want to feel just fine throwing 7 of them out. If you cast a wide net – if you settle for cheap enough – you can get lists of 10 stocks (I’ll show you a few in a minute) where there probably are at least 3 names you’d feel comfortable researching in earnest right now.

I get a lot of people emailing me about companies involved with for-profit education, medical services dependent on government reimbursement, lawsuits, commodities, etc.

There’s nothing wrong with any of those things if you think you can figure it out. You can focus on absolutely hated stocks if you want to. There’s money to be made there. But you’d want to become an expert on the unloved. Likewise, any stock with legal problems is interesting precisely because the accuracy of your analysis of the legal situation may be all you need to know to invest in the stock. It could actually be very simple. If you have a way of understanding the lawsuit.

I’ve invested in a company where a lawsuit was critical to the stock’s value. But I didn’t do it because I found the stock on some screen. I read about the stock and the lawsuit on a blog. And then I went off and tried to learn everything I could about the stock.

That’s fine.

What you need is a very early – almost instant – feeling of “I may not know this now. But given enough time, I’m confident I can figure it out.” You want to feel that very early in the process. Or you’re going to waste a lot of time analyzing a stock from 30 different angles – when the one angle that matters is the one you can’t reliably figure out.

So extreme quantitative screens are usually not the best starting point. It’s better to caste a wider net and then focus on companies where you can get a lot out of reading the 10-K.

Try a screen like one that combines:

· Above average dividend yield

· Below average P/E ratio

· Below average P/B ratio

Look for companies that have the fewest unprofitable years in their past. The stocks that tend to almost always have positive EPS. This will give you a list like:

There’s probably a company or two on that list you feel is in your circle of competence. Start with the company you expect you’ll understand best – the one that sounds simplest to you – and then move out slowly and carefully to the companies you expect to understand less well. Stop when you find something you know is cheap that you also know you can hold as long as it takes.

That’s a Ben Graham type screen I just gave you. But you can apply the same principles to more Warren Buffett type stocks. Or at least more Joel Greenblatt type stocks.

How about we look for “cheap enough” in terms of:

· EV/EBITDA

· Return on Investment

I like to think of this as establishing an acceptable limit. It’s not a hard cap. But you better have a really good reason for paying an EV/EBITDA over 8. And you better have a really good reason for buying any company with an ROI below 10%.

There are companies you should buy above 8 times EBITDA. And there are times when a business will work out fine in the future even though it’s been earning a single digit ROI in its past.

But trying to figure those situations out before looking at the simplest situations is like trying to learn to juggle using 3 balls at once. It’s not the best way to start.

This is totally arbitrary. But I’d suggest an acceptable stock is one with:

· EV/EBITDA< 8

· Return on Investment > 10%

· 10 Straight Years of Profits

(When I say profits – I always mean operating profits, never just EPS.)

You need a good reason for picking any stock that doesn’t fit all of those criteria. You don’t want to make a habit of paying more than 8 times EBITDA. You don’t want to make a habit of buying into companies that aren’t growing their value over time – but instead earning single digit returns on investment.

So start with the stocks that can check those boxes. Read the business descriptions of each. Start with the businesses you think you can figure out.

That higher ROI menu you’d be ordering from would look something like this:

I’m not saying those stocks will outperform a basket of all net-nets. I don’t think they will. But I do think you will outperform other net-net investors if you start with stocks like that. Because you can understand stocks like that. You can have the conviction to hold them when they drop.

Most net-net investors will underperform a basket of net-nets. Most magic formula investors will underperform a basket of magic formula stocks.

That’s just the way it works. Picking stocks from lists like these – and then letting yourself make additional buy and sell decisions over time – will usually result in you doing worse than a completely random basket approach.

There is one way of solving this problem. Familiarize yourself with a few stocks. Get really familiar.

People think insiders are such good investors because they have a lot of inside knowledge – they know what’s about to happen. I tend to think that’s exaggerated. They have information. But a lot of the data on insider trades tends to point more to insiders having strong stomachs.

What insiders have is familiarity. They know the actual company. When it seems like a stock is dropping for no reason – they will buy it. Not because they are better at valuing the company. But because they are a little less likely to get caught up in hysteria.

What you’ll see in the charts is that insiders do something very smart – something individual investors do not do – they buy more of the stock they own when it crashes.

While strategies like just randomly buying net-nets do in fact work well if implemented by a computer – I’ve seen very little evidence humans will have success with the strategy.

Humans do not do well with stocks they really don’t know.

For your long-term investing health, it’s better to find a slightly less cheap – but still cheap enough – stock you can get familiar with than a super cheap stock that will always remain a mystery to you.

Start with cheap enough. Then learn more about the businesses on that “cheap enough” list. And buy the ones you are comfortable with.

I’m not saying you should give up the statistical search for value. You can always stay in the bottom half of stock valuations and still find companies you understand well.

This is especially obvious in net-net investing. If I write about a stock trading at 90% of its net current asset value – someone will say that’s not a true Ben Graham net-nets. It needs to be selling for 65% or less of NCAV to be a real net-net.

Anything less than NCAV is cheap enough. You’ll have more success with the net-nets you feel most comfortable owning than with net-nets you’ll get scared out of.

That’s true for other value stocks too.

Some of value investing is in the buying. Most of value investing is in the holding. And almost none of value investing is in the selling.

As long as you are starting with a screen that produces results which – as a group – will tend to perform better than the market over time, you’re doing enough in terms of statistical cheapness.

The next step is to learn about the business. And get comfortable holding the stock.

Because it’s not just about how the stock does in the future. It’s about the result you get in the stock. And that depends on you sticking around to see your investment through.

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Comments

How many stocks is Geoff comfortable following? I read in a previous article he sticks to 10 stocks, as he is unable to mentally juggle more than that.

Also, he says "settle for cheap enough". I find it amazing there are people out there screening for stocks at all-time low P/B, P/E and making investment decision on those facts alone! Like he says, that is simply a starting point from where the homework must take off from. Then he says it is an odd way to screen for stocks - for the obvious reason that the companies listed will be all over the map in terms of quality. Couldn't agree more on that one - and it seems a little bit of a no-brainer too btw.

The way I do it is first get a big list of companies that pass a high quality mark, then keep track of them for low and sinking P/B. But even then all I'm doing is getting the stocks that are sinking early vs. the stocks that sink late. As Buffett said, you have to separate the company from the stock market - the two components that together make an investment. When the once-in-five-years Dow lows come along, it is entirely possible that the early low P/B companies are the first to rise again - haven't done that research yet.

Also have to mention that Geoff's decision to start a series of articles with the title Value Investor Improvement Tip is excellent! I am looking forward to more of these practical articles. To be honest, I am one of those average/slightly below average intelligence investors who gets more than a little lost in Geoff's Mensa-level articles. LOL

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